Exiting a Corporate Investment Without a Tax Backlash

It’s becoming a problem, a decidedly “high class” problem, but a problem nonetheless. The problem is rooted in a phenomenon of recent years in which an “operating company” owns an interest in another company whose stock has performed spectacularly well, often better than the investor company’s shares. As a result, the market value of the stake approaches, and sometimes exceeds, the entire market capitalization of the investor company. This situation has regularly recurred as companies of all types increasingly have injected equity capital into young technology companies with high-flying shares and the incidence of IPO equity carve-outs of divisions and subsidiaries has grown. Managers of the investor/parent companies rarely are applauded for shrewd value-creating decisions. Rather, they face a squeeze. Shareholders often want the valuable stake to be sold off quickly, but divesting it without careful planning can leave the company with a huge tax bill that offsets much of the gains. A key source of the problem is that once the value of the portfolio stake is subtracted, the stock market ascribes an unduly low (and sometimes negative) valuation to the remainder of the investor company’s assets and business. Shareholders become increasingly restive and demand that management take steps to cure this anomaly – in most cases by separating the portfolio stake from the balance of the operating company’s assets. Management, motivated in part by self-preservation instincts, normally will be amenable to such a suggestion, but all interested parties want the separation to be accomplished on a “tax-efficient” basis. Thus, the “divorce” that the shareholders are clamoring for must be carefully structured. The goal is to preferably eliminate, or at least defer, the tax on the gain inherent in the investment, which has appreciated widely over its tax basis in the investor/parent company’s hands. Fortunately, there are techniques available to accomplish the separation on a tax-advantaged basis. Spin-Offs A tactic that will result in permanent avoidance of the tax consequences of the divestiture is a tax-free spin-off of the stake, qualifying under Section 355 of the Internal Revenue Code (IRC). However, before such a spin-off can take place, certain crucial preliminary steps must be taken. A direct distribution of the stake, without accomplishing these preliminary steps, will create nothing short of a tax disaster. For example, Section 311(b) of the code requires a corporation that distributes appreciated property to its shareholders to recognize the gain inherent in such property as if the property had been sold (to the shareholders) for an amount of money equal to the fair market value of the property. To add insult to injury, the shareholders would be in receipt of taxable dividend income measured by the fair market value of the distributed property. The distribution can be converted into a tax-free spin-off if the requirements of Section 355 can be met. Most notably, the distributing corporation must, immediately before the spin-off, control the corporation whose shares and securities it is distributing. For this purpose, control (as defined in Section 368(c)) means ownership of at least 80% of the total combined voting power of all classes of stock entitled to vote and 80% of the total number of shares of each class of non-voting stock (if that exists). Invariably, the investor company will not, at the inception of the transaction, own a controlling interest in the portfolio company. However, in light of the odd definition of control contained in Section 368(c), which focuses on ownership of stock possessing voting power and does not require the ownership of any particular percentage of the value of the outstanding stock, the requisite control is rather easily gained. A good technique to gain the required control was exemplified in the recently completed spin-offs of interests owned by IMS Health in Gartner Group Inc. and by Harcourt General Inc. in Neiman-Marcus Group Inc. The portfolio company created a new class of stock, the holders of which are entitled to elect at least 80% of the members of its board of directors. This class thereby possesses 80% of the voting power of all classes of stock entitled to vote, since voting power is a function of a class of stock’s proportionate ability to elect directors. In a second step, the investor company, with shareholder approval, swapped the stock owned in the investee for the newly created class of “high-vote” stock, the ownership of which afforded it control. The high-vote stock then was distributed by the investor company to its own shareholders in a tax-free spin-off. Thus, IMS and Harcourt turned its direct investments over to its shareholders, who gained positions in Gartner Group and Neiman-Marcus without incurring taxes. The preliminary stock swap is a tax-free exchange because it qualifies as a recapitalization and, hence, a tax-free reorganization under Section 368(a)(1)(E) of the IRC. This is important because the tax-free nature of the stock swap enables the spin-off to meet the “active business” requirement of the law. That test is met if both corporations, immediately after the spin-off, are engaged in the active conduct of a trade or business that has been actively conducted throughout the five-year period ending on the date the shares are distributed. In addition, control of the corporation conducting the business (in this case the investee company) cannot have been acquired by another corporation, within the five-year period, in a wholly or partially taxable transaction. Thus, although the investor company acquired control of the portfolio company within the five-year period preceding the distribution, the active business test still is met because control was acquired in a permissible manner, via a fully tax-free recapitalization. One problem remains. The portfolio company will be saddled with two classes of stock for the foreseeable future. The Internal Revenue Service (IRS) frowns on any attempts to “recombine” the classes and reprise the portfolio company’s “simple” capital structure. The presence of the high-vote stock, therefore, may leave it vulnerable to a “cheap” takeover since a determined raider can gain voting control of the company for a relatively modest investment. To guard against an unwanted takeover, Gartner Group instituted a charter amendment that the IRS somewhat surprisingly accepted. Under the change, a holder of at least 15% of Gartner’s high-vote stock can only vote that stock if, and to the extent that, the holder owns at least an equivalent percentage of its low-vote stock While this charter amendment does not preclude a takeover, it certainly seems to discourage an opportunistic bid. It should be seriously considered by any investee company that finds itself involved in a spin-off that necessitates the creation of a high-vote class of stock 1. Downstream Mergers Another technique that will forever eliminate the tax on the gain inherent in the portfolio stake is a “downstream merger.” This strategy, however, does involve an element of taxation because, in most cases, the investor company will be required, prior to the merger, to dispose of its other assets so that, at the time of the merger, its only asset is the stock of the portfolio company. In the past, the disposal, if structured as a spin-off of “unwanted assets,” could have been accomplished on a tax-free basis. A primary example was the legendary spin-off by Affiliated Publications Inc. of its much-appreciated interest in McCaw Cellular Communications Inc. to its shareholders. It was a variation of the Morris Trust transaction, a spin-off of the unwanted assets followed by a stock-for-stock exchange involving the distributing corporation, which then contained only “wanted” assets and a merger partner. However, in 1997 Congress enacted Section 355 (e) of the IRC, which removed tax-free status (at the corporate level) in Morris Trust transactions where the shareholders of the investor company do not wind up with more than 50% of the voting power and value of the stock of the merger partner. The downstream merger approach was utilized by Petrie Stores Co. with respect to its stake in Toys R’ Us Inc. and is in the process of being implemented by Seagate Technology Inc. in its attempt to avoid the taxes inherent in disposing of its 32% stake in Veritas Software Corp. In the Seagate deal, the company plans to engineer a preliminary sale of its disk-drive business to a group led by management and Silver Lake Partners for $2 billion (a sale that some shareholders believe is at a bargain price). That sale will be immediately followed by a reverse triangular merger in which a Veritas subsidiary will be funded with Veritas stock and then merged into Seagate. In the merger, by operation of law, the subsidiary’s stock will be converted into Seagate stock and Seagate will become a wholly owned subsidiary of Veritas. The Seagate stock will be converted into Veritas stock. At the end of the day, the effect of the transaction is that Seagate has distributed its Veritas stock to its shareholders on a tax-free basis. It could not obtain that treatment if an “outright” distribution of such stock had been attempted. Veritas benefits from accommodating Seagate’s tax-avoidance predilections. In the merger, it will issue a smaller number of shares than the number previously held by Seagate. Thus, it gets to retire a substantial amount of its stock at no cost, and will emerge from the transaction with an immediate boost to its earnings per share. Seagate, for its part, is willing to cede this benefit to Veritas. In effect, Seagate is simply sharing with Veritas – the only merger partner that could abet it in accomplishing the desired tax savings – a portion of the tax savings that the merger affords. The balance of such tax savings (the numbers suggest that they are being shared equally) inures to the benefit of the Seagate shareholders. The technique only works, however, if the merger constitutes a tax-free reorganization. If it does not, the Seagate shareholders will be taxed on the exchange of their Seagate stock for the Veritas stock. However, because the merger is structured as a reverse triangular merger in which Seagate’s corporate entity is preserved, Seagate would not be taxed on the gain associated with its Veritas stock. If the downstream merger is structured as a “straight” merger or as a “C” reorganization – the Petrie Stores approach – both the shareholders and the merging corporation would incur tax, if the transaction does not qualify as a reorganization. The principal impediment to reorganization treatment appears to be the continuity of business enterprise requirement. That requirement tells us that reorganization treatment is dependent on the acquiring corporation’s continuing the target corporation’s historic business or using a significant portion of the target’s historic assets in subsequent operations. In the prototypical case, the target’s historic business has been disposed of immediately prior to the merger so, on the surface at least, it appears that the continuity of business enterprise test cannot be met. However, in Revenue Ruling 85-197, which addressed a downstream merger, the IRS concluded that the business of a holding company that merged into its operating subsidiary was the parent’s business. Thus, after the merger, the holding company’s historic business – that of its operating subsidiary – was, indeed, continued. In the ruling, however, the holding company had never conducted a business itself, and the facts disclose that the holding company’s only asset consisted of 100% of the stock of the operating company. The downstream mergers, which are being used here to liberate an appreciated portfolio stake, do not conform to that “clean” fact pattern. Nevertheless, the belief is that the ruling’s conclusions are not confined to situations involving the simple fact pattern covered by the ruling. Thus the belief is that Seagate, like Petrie Stores before it, will qualify as a holding company whose historic business, for continuity of business purposes, will be considered the business of Veritas 2. Monetization Another tactic that can be employed to great advantage, although it only features a deferral of the inherent tax, is the monetization of the portfolio stake. This approach is frequently implemented through the sale of an exchangeable debenture. The investor company borrows an amount approximately equal to the current value of the portfolio stake yet defers the tax on the inherent gain until the debenture holders exercise their exchange rights and take delivery of the underlying portfolio stock, assuming that ever occurs. Although, in some ways, this hypothecation of the portfolio stake can be seen as a sale, it is not treated that way for tax purposes because the arrangement does not amount to a constructive sale within the meaning of Section 1259 of the IRC. That section provides that a taxpayer has constructively sold an “appreciated financial position” if it enters into a short sale of the same or substantially identical property, enters into an “offsetting notional principal contract” (e.g., an equity swap) with respect to such property, or enters into a futures or forward contract with respect to the property. In light of the fact that even a mandatorily exchangeable security has been ruled not to constitute a prohibited futures or forward contract (because it is not a contract to deliver a substantially fixed amount of property for a substantially fixed price), it follows that an optional exchangeable debenture does not create a constructive sale of the appreciated portfolio stake. The operating company raises a substantial amount of cash by selling the debenture. Yet it defers the tax on the gain inherent in the property that underlies the cash infusion. In addition, the seller of the exchangeable debenture realizes another important benefit courtesy of the IRS’s contingent payment debt instrument rules. It is clear that an exchangeable debenture constitutes a contingent payment debt instrument (CPDI). When issued for cash or publicly traded property, the CPDI must be accounted for under the “non-contingent bond method.” This means that the issuer must identify the instrument’s “comparable yield,” i.e., the yield at which it would issue a fixed-rate security that possesses comparable terms and conditions. The comparable yield of an exchangeable debenture will invariably be significantly higher than the stated yield on such an instrument. The issuer, then, must develop a “projected payment schedule” for the security, and this projected payment schedule must produce the comparable yield. Thus, the projected payment schedule consists of the instrument’s semiannual coupon payments and a projected terminal value which, taken together, provide the holder with a yield corresponding to the comparable yield. The result of all of these calculations is a bond deemed to be issued with an original issue discount (OID), because the bond’s redemption price at maturity – the projected terminal value – exceeds its issue price. The issuer, therefore, achieves an advantage because it is able to deduct the OID on a constant interest basis over the life of the debt instrument. Thus, the issuer enjoys “phantom” interest deductions because, in addition to deducting the modest stated interest on the bond, it also accrues and deducts the OID. The cash flow benefit one obtains from tax deductions that do not involve a concomitant outlay of corporate resources make a portfolio exchangeable debenture an exceedingly attractive form of financing. What happens if the underlying stock does not appreciate over the term of the instrument and, as a result, the projected terminal value is never realized? In such a case, the issuer must “recapture” the phantom interest deductions which, events have proved, were taken erroneously. However, the recapture occurs at the time the bond matures or is otherwise retired. At that time, the issuer reports, as ordinary income, an amount equal to the “excess” deductions. Nevertheless, even here the issuer realizes a permanent benefit. It is clear that the present value of the tax imposed on such ordinary income is substantially smaller than the present value of the tax savings enjoyed from deducting identical amounts, from inception, over the life of the instrument. Thus, for these reasons, monetization is clearly a viable strategy for wringing substantial benefits from an appreciated portfolio stake. “Bad” Morris Trust Flowers Industries Inc. is sitting on a highly appreciated portfolio stake represented by its 55% interest in Keebler Foods Co. Flowers’ other assets, its baking business, have a high tax basis relative to its fair market value. This set of facts lends itself to a final strategy, the one also being employed by Aetna Inc. with respect to its sale of its financial services and international units to ING Group NV in a so-called “bad” Morris Trust transaction. Flowers has announced that it will spin off its baking business and, as part of the plan, Flowers shareholders will sell their Flowers stock to whoever acquires Keebler. The spin-off fails to qualify as a tax-free spin-off under Section 355. Among other things, a spin-off that is coupled with a taxable sale of the stock of either party to the spin-off causes the transaction to flunk the so-called “device” requirement. A spin-off cannot qualify as tax-free if the transaction is used principally as a device for the distribution of earnings and profits. That test typically applies where, as in the Flowers case, a parent distributes the stock of a subsidiary,pro rata to shareholders who, pursuant to a pre-arranged plan, sell the stock of either company for cash while maintaining, intact, their equity interest in the unsold corporation 3. Thus, because the transaction is not a tax-free spin-off, Flowers would, under Section 311(b) of the IRC, be required to recognize the gain associated with the baking business. However, because this business possesses a tax basis that in all probability exceeds its value, there is no gain for Section 311(b) to tax. Moreover, because the second step is a sale by the shareholders of their Flowers stock (Flowers at this point is a shell corporation whose only asset is a 55% holding in Keebler), the appreciated Flowers assets, i.e., the stock of Keebler, never leaves “corporate solution.” Therefore, the gain inherent in such stock is never triggered into income. Thus, the separation of the baking business from the Keebler stock will not, in the final analysis, trigger any corporate-level tax obligations. Accordingly, a bad Morris Trust transaction is most profitably used in cases in which the corporation possesses two groups of assets – one that is appreciated and another, which actually gets extracted from the corporation, that has a tax basis exceeding its value. A bad Morris Trust transaction does create shareholder-level taxation. However, that tax should only be assessed at the preferential rates associated with long-term capital gains on shareholders who have held their stock for more than 12 months. Thus, it is widely believed that the shareholders should be seen as selling their stock in the operating company for a combination of the cash to be paid by the buyer plus an amount equal to the fair market value (determined by its trading price on the date of distribution) of the stock of the “stub” corporation. The excess of this “amount realized” over the basis of the stock of the operating company, in the hands of the selling shareholders, yields a capital gain. This approach, which is derived from the application of the “integrated transaction” doctrine, is the consensus view of the tax profile of a bad Morris Trust transaction. It is likely to defeat the “form” of the transaction which, if it was followed, would result in taxation of the distribution of the “stub” as ordinary dividend income. One other issue involves the fact that the buyer of the Flowers stock will inherit the company’s low basis in the Keebler stock. Presumably, the buyer will “penalize” the Flowers shareholders, through the mechanism of a lower purchase price, for this infirmity. Why? This low basis may come back to haunt the buyer if it ever decides to sell its Keebler stock. This problem presumably can be avoided if Flowers chooses to follow Seagate’s lead and effects a downstream merger, where Flowers merges into Keebler, immediately following the spin-off. After that, the buyer of Keebler can purchase Flowers’ stock directly from its holders (the minority Keebler shareholders and the former Flowers shareholders) and obtain a “cost” basis, rather than a low inherited basis, in all of the Keebler stock. It appears that such a downstream merger would benefit the Flowers shareholders because it would eliminate the “basis discount” they are likely to suffer if the buyer is forced to purchase their Keebler stock indirectly through the acquisition of the stock they own in Flowers. In any event, a corporation faced with the necessity of separating its operating business from its appreciated portfolio holdings has a menu of alternatives from which to choose. Such a separation can occur on a tax-advantaged basis and the operating company’s shareholders can realize, when the spin-off or downstream merger alternative is selected, the full pre-tax value of the appreciated portfolio stake.